The Markets February 1, 2018

Rising Rates Bring Bond Duration and Supply Questions to the Fore

Vanguard’s lead actuary for the OCIO pension support business sounds a clear note of caution about attempting to “beat the rush” into long corporate bonds that could come along with a sharp rise in rates; Northern Trust experts explain how ultra-short duration funds can benefit DB plans today.
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Brett Dutton has served for the last two years as lead actuary for defined benefit (DB) plans within the Vanguard Investment Advisory Services unit; this is Vanguard’s outsourced chief investment officer (OCIO) business, which partners with clients on the management of their pension plan portfolios, among other activities.

Sitting down with PLANADVISER to discuss a thought-provoking blog post he recently published, Dutton noted that he serves quite a large number of diverse clients—so his daily role ends up being a pretty broad one when it comes to delivering on actuarial functions in this side of the business.

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A lot of the time when a Vanguard investment consultant gets a tough question or query from a pension client, Dutton will be asked to come in and help form an answer and deliver that response. Recently one difficult question in particular has been coming up with real frequency: “Our consultants are being asked by pension plan clients across the board, should we be concerned about the potential of a drying up supply of long-duration corporate bonds as interest rates rise?”

The concern is coming from a somewhat complicated set of dynamics, starting with the fact that the current supply of long-term corporate bonds is about, very roughly speaking, $1.5 trillion, and in recent times there has been, again very roughly speaking, a steady inflow of new issues. A few trends have even pushed the flow of new long-term corporate bond issues slightly higher, for example because corporate borrowing has been lower, resulting in companies looking at securing financing more through the bond markets than via bank lenders. There is also a trend emerging, as Dutton put it, towards “enriching the value of equity holders,” and doing this by creating more leverage through bond issues.

“This type of move, we can see, has been increasingly attractive,” Dutton said. “So in recent times there has been this steady drumbeat of new long-term corporate bond issues. What we are now starting to see emerge, however, is a real fear that forthcoming interest rate increases will start to dry up the supply of new bond issues.”

This would obviously be a problem in the client base because pension plans in general hold very large volumes of corporate bonds. It is always a difficult proposition to figure out which bonds should be held and for what duration—and of course this would be complicated by issues of decreasing supply driving up costs.

“A lot of plan sponsors, including our clients and others, they have been waiting on the sidelines to see what will happen with long-term corporate bonds,” Dutton continued. “They know that eventually they want to de-risk with more long bonds, but there is a fear holding them back because of the current interest rate environment, and where long-term rates could go in the short and mid-term future. They want to buy long-bonds someday. They don’t want to do it today, however.”

If one starts to flesh this stuff out and runs the numbers, one can understand why Dutton’s clients are starting to say this is a top concern. There is $1.5 trillion in long-corporate bonds available with more than 10 years until maturity. This compares with $3 trillion in corporate pension assets.

“If a wave comes where a lot of plan sponsors at the same time decide that they want to be more heavily invested in this market, they may actually have a hard time finding the bonds they’re looking for,” Dutton explained.

Even with this warning about the possibility of a rush into long-term corporate bonds based on interest rate movements, Dutton said it is very important to stress that one should not try to time the market here.

“Just as we would say on the equity side, nobody has a crystal ball,” Dutton said. “The dynamics may change in the future and lead to something of a rush into corporate bonds, crunching the supply, but we cannot know when change will come or exactly what the future will look like. So what we tell clients is basically this—there are questions about what the corporate bond market supply could look like in the mid-term future, but given what we know right now, it is not worth deviating from your strategic objectives out of a fear for what could happen.”

Another way to say this: Don’t act out of a sense of trying to beat the rush. It may be smart for more plan sponsors to move into more long-term bonds today, but they shouldn’t do it out of a sense of trying to beat other pensions to the punch.

“I work with Vanguard and our philosophy is ‘stay the course,’” Dutton concluded. “We determine what the strategic objectives of your pension plan are—and then from there you design a broadly diversified portfolio around that. Stick to this plan even when there is some turbulence in the market.”

Broader pension plan challenges

Taking a step back, there are other broad challenges facing pension plans worth pointing out right now, Dutton said.

“I have mentioned that some of our clients have decided to sit on the sidelines, in a sense, given the lasting uncertainty and confusion about the abnormal rate environment that has been the rule since the Great Recession,” he observed. “I think it is important to understand and sympathize with how vexed some clients can be in this environment. Let’s say that you only got involved in being a plan sponsor five or even 10 years ago at this point. This whole time you would have been operating in an ‘abnormal’ interest rate environment that has just been so stubborn. Now you are seeing signs of a slow return to ‘normal,’ but again for many folks, they have not operated in a ‘normal’ environment for so long.”

It all begs the question, what even is “normal” at this point when it comes to thinking and talking about interest rates?

“Our messaging to clients in response to all of this has evolved more towards encouraging them to accept the reality of the environment we are in today and to, again, not frame the investment strategy around what amounts to a bet that long-term interest rates are going to rise quickly at some point in the near or mid-term future,” Dutton said. “Sponsors see what the Federal Reserve is doing on its target-rate and how this has an impact on the shorter duration end of the spectrum, but they also need to understand that the Fed only has very little control, if any at all, around what will happen with the long-duration end of the yield curve. There is no obvious evidence right now that long-rates are going to jump significantly. They could at some point, certainly, but the market as a whole does not seem to imply this right now, on our economic view.”

Dutton’s broad conclusion is that plan sponsors “must think deeply about their true strategic objectives, and how these can play out both in the short term and the long term. They must be very cautious about taking tactical bets on what amounts to speculation about what could happen in the mid-term.”

Strategies as rates rise

According to Colin Robertson, Northern Trust Asset Management managing director of fixed income, and Morten Olsen, director of ultra-short fixed income, history shows that “ultra-short funds” offer an effective means to manage liquidity and gain income in a raising rate environment—potentially an opportunity to get off the sidelines, as Dutton framed it.

As Robertson and Olsen set out, investors who think money market funds are safer in a rising-rate environment “should look at the long-term historical record.”

“In past rising-rate environments, cash (money market) strategies have outperformed slightly longer ultra-short strategies only for brief periods,” they warned. “In all rising-rate periods over the last 20-plus years, ultra-short strategies had no negative returns in a rolling 12-month period either. Of course, past performance is no guarantee of future results.”

Offering some helpful context, Robertson noted that “ultra-short fixed income strategies” may be an attractive option for investors seeking to improve performance and limit principal volatility, even in rising interest rate environments. “The ultra-short strategy covers the yield curve from one day to three years for fixed rate securities, thus providing some of the stability and liquidity of money market funds and the higher return potential of short duration bond portfolios,” Robertson said. “Investors willing to increase risk modestly potentially can realize higher current yields and total returns with ultra-short strategies.”

According to Olson, the investment objectives of ultra-short solutions are to outperform money market funds on a total return basis by taking modest interest rate, credit, and liquidity risk. “Whereas money market funds operate with interest rate duration up to two months, ultra-short strategies tend to have durations of around six months to one-and-a-half years,” he explained. “Ultra-short strategies are able to invest in securities outside the traditional money fund opportunity set, including longer-term fixed and floating-rate agencies, corporate bonds, and prime asset-backed securities.”

The pair suggested the most recent period offering meaningful insight into the effect of rising interest rates on an ultra-short portfolio is 2004 through 2006, when investors experienced 425 basis points (4.25%) of short-term rate increases in the United States. During this period ultra-short funds outperformed money markets.

“For shorter investment horizons (e.g., rolling three-month performance), negative returns may occur, highlighting the importance of considering the investment horizon when choosing a strategy,” Robertson and Olson concluded. “While ultra-short strategies may experience short-term underperformance when rates rise, investors can attain attractive returns over these strategies’ targeted durations. By combining money market funds and ultra-short solutions, investors can seek to meet liquidity needs with meaningful returns and without undue risk.

“Investors should examine and segregate those balances that require immediate liquidity versus those that are available for a longer investment horizon. … Although many investors are happy to accept a lower return for the peace of mind that comes with a money market fund, other investors with a longer investment time horizon may find the opportunity for incremental returns well worth the modest additional risk from an ultra-short strategy, even during periods of rising short-term rates.”
The Markets January 18, 2018

NYC Public Pension ESG Investing Debate Renews a Fight Familiar to Some

Recent criticism of public pensions’ sizable push into ESG investing echoes valid concerns voiced in the past—but the ecosystem of environmental, social and governance investing has matured in ways that remain unacknowledged by some critics.
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The end of 2017 and the first few weeks of 2018 brought a renewal in the longstanding debate surrounding the merits of environmental, social and governance (ESG) investing programs enacted by public and private pension plans.

Case in point is the series of sharply written, dueling reports in which experts from the American Council for Capital Formation (ACCF) and CalPERS debate the proper role of environmentally and socially conscious investments—and whether the massive California public pension fund has grown too political in its actions.

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On the East Coast the debate has fired up as well, prompted by New York City Mayor Bill de Blasio, Comptroller Scott Stringer and other trustees of the city’s $189 billion pension funds. The city’s political leadership recently announced a goal to fully divest city funds from fossil fuel reserve owners within five years, which they say would make New York City’s the first major U.S. pension plan to do so. Practically speaking, the mayor and comptroller pledged to “submit a joint resolution to pension fund trustees to begin analyzing ways to divest from fossil fuel owners in a responsible way that is fully consistent with fiduciary obligations.”

In total, the city’s five pension funds hold roughly $5 billion in the securities of over 190 fossil fuel companies, according to data provided by the city. Given those numbers, the city’s move, the mayor and comptroller claim, is among the most significant divestment efforts in the world to date. Several New York City pension fund trustees declined to return requests for further comment, but there is some additional insight into the city’s thinking published in media reports and on government websites. Stringer, for example, is quoted variously as saying this effort is admittedly fraught, complex and that it will take time—but he feels it is fully legal and in keeping with the fiduciary duties of prudence and loyalty owed to public pensioners.

“There are going to be many steps,” he has told reporters. “But we’re breaking new ground, and we are committed to forging a path forward while remaining laser-focused on our role as fiduciaries to the systems and beneficiaries we serve.”

Just as with the CalPERS challenge, the New York pledge to move down the road of ESG has already resulted in significant criticism and pushback from lobbying and advocacy groups sympathetic to the concerns of large asset owners and other stakeholders. ACCF, in fact, has published another report suggesting, as it did with CalPERS, that New York City’s push to divest its investments in fossil fuels “are a recurring example of the city comptroller advancing social causes over financial results.”

The ACCF report seeks to paint the divestment as “just one example of politics taking precedence over returns for New York City beneficiaries.”

“Fund managers responsible for the pension-fund system of New York City routinely invest in things that have no reasonable expectation to yield acceptable returns for investors,” argues Tim Doyle, ACCF’s executive vice president and general counsel, and author of the report. “We concur with previous reports on the role that poor management has played in growing the unfunded gap, as well as how the use of certain accounting tactics has allowed fund managers and the comptroller to shield from public view the true consequences of their mismanagement.”

According to ACCF, “four out of every five taxpayer-dollars collected by New York City’s personal income tax are spent paying down the city’s public pension fund system’s liabilities, a 567% increase over the past 15 years. The city’s budget will soon allocate more spending on pension costs than on social services (excluding education).”

Public data shows the New York City pension funds’ liability ratio is self-reported at $56 billion. But Doyle says this figure is inaccurate: “Other analyses based on more realistic projections of future returns point to an actual funding gap more than double the official figure.”

As with the CalPERS matter, readers of the ACCF report will have to dig into the reporting and draw their own conclusions—but it is worth pointing out that the ACCF’s arguments, while articulate and important, do not necessarily do full justice to ESG as a broad topic. Indeed, proponents of environmental, social and governance investing say opponents of the philosophy have unfairly worked to define it as a foolishly motivated privation—as the sacrifice of lucrative energy and oil company stocks because of irrelevant moral discomfort. A rational ethical scheme, perhaps, but not an approach that is financially sound for the spending of taxpayer dollars. 

For a while the criticism made much more sense in the fiduciary institutional investing world. The earliest generations of ESG portfolios took the form of standard equity indexes with energy and other higher-waste sectors and stocks cut out. It’s a practice known as “negative stock screening,” and today much of the opposition to ESG is still caught up in this initial association with stock screening. This is despite the fact that the Department of Labor has modernized its stance and no longer requires that ESG factors be considered as nothing more than a potential tie-breaker by qualified retirement plan fiduciaries. As the DOL has directly acknowledged, ESG factors can be used in much more sophisticated and productive ways. (For its part, ACCF agrees theoretically with this possibility in one part of its criticism, accusing New York City of failing to live up the real possibilities of modern ESG investing.)

Many investing experts, including David Richardson, executive director, global head of marketing and client service at Impax Asset Management, have told PLANADVISER the association between ESG and negative stock screens is unfair and no longer accurate.

“Frankly that outlook is completely outdated,” Richardson says. As the name suggests, Richardson’s firm focuses on ESG investing portfolios and, as he puts it, “delivering superior performance by taking ESG factors seriously.”

The work involves much more than negative stock screens, he notes, and includes deep analysis of how specific companies and sectors use resources and process waste—as well as how they stand to gain or lose in the long-term from carbon pollution, recourse scarcity and climate change. In this way, ESG portfolios are built not to make an ethical stance, but to take advantage of the superior growth demonstrated by companies that do business in an ethical and environmentally sustainable way. And so it must be said, when presented honestly, few would argue that considering ESG factors is an outright bad idea when building investment portfolios with the very long-term time horizons faced by public pensions.

“Put simply, today’s ESG is a sophisticated and potentially very compelling investing principle going far beyond stock screening,” Richardson adds. “It’s not just Impax saying this. There are a variety of United Nations reports circulating that argue the same thing, urging all of us to start taking ESG seriously as a means to protect our finical futures.”

This line of argument will have to be articulated more clearly as the city—and other public pension funds across the U.S.—defend their decisions to leverage ESG, both in court and in the public consciousness. Also relevant is that New York City officials have separately filed a lawsuit against the “five largest investor-owned fossil fuel companies as measured by their contributions to global warming.” The city will be “seeking damages from BP, Chevron, ConocoPhillips, Exxon Mobil, and Royal Dutch Shell for the billions of dollars the city will spend to protect New Yorkers from the effects of climate change.” This includes damages to pay for harms already seen and damages that are necessary to address harm expected to happen over the course of this century.

With such a challenge, the pension officials are clearly trying to demonstrate the material nature of ESG factors on financial performance in the short- as well as long-term.

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